Thursday, October 18, 2012

How to prepare for next time

Let's face up to the fact that our government is not going to try and stop "running" the economy any time soon and think about ways to limit the damage they do.

When it comes to macro policy, there are two no-brainer reforms that would really help.

First, I agree with Ryan Avent (really). Raise the inflation target to say, 3.5%, but INDEX all tax brackets so that the higher inflation can be more neutral.

There clearly is a "discontinuity" in the Fed's reaction function when nominal rates hit zero, and a higher inflation target can help avoid this situation.

Second, I agree with JM Keynes (really). Counter-cyclical fiscal policy is a good idea. Surplus in the booms, deficits in the downturns. Chile has figured this out for Pete's sake, why can't we? Balance the budget over the business cycle.

People, I don't think the Fed can control real GDP. I think the Fed has done a decent job controlling inflation over the last 30 years, and they did a great job throwing the kitchen sink at the financial system and preventing a full meltdown / depression. I don't think there is a magic monetary policy the Fed could have been following that would have either avoided the downturn or given us a quick and robust recovery. I do think that zero bound problems were not sufficiently appreciated and a modestly higher inflation target could help us from smacking into them.

Neither do I think that fiscal policy has big multiplier effects (though I admit to being intrigued by the idea that at the zero bound, the effects are perhaps greater than 1), but you know that in troubled times it will be used. Let's just stop shooting ourselves in the foot by running big deficits in the good times as well.

We are not going to get rid of policy actions in downturns. But if our policymakers were operating from better baseline positions (further from the zero bound, further from an explosive level of debt), these policy actions would be much more effective and carry lower long term consequences.

Is there a political mechanism that can insure balancing the budget over the business cycle? If it requires that we elect the right people (or at least a majority of right people in both houses of Congress), I can't say I'm too optimistic about it.

Is there a political mechanism that can insure balancing the budget over the business cycle?

The only way to do this is to make politicians liable for deficits. The solution I've thought if is that if the years deficit is x% of the budget, then all congressmen, senators, the president and cabinet level appointees, and the supreme court justices be taxed on all income an extra x%, on top of the current tax code, and have their total net worth taxed at x%. If their net worth is zero or less, then only their income will be taxed.

In addition to this, another tax will be levied based on the total debt relative to GDP, in a similar manner.

I'm pretty sure if this was implemented, it would be shocking just quickly the deficit would be eliminated and how quickly the debt would be reduced. I, also, think these reductions would occur with minimal loss in government services.